Mortgage-Backed Securities Losing their Stigma - What we can learn from the current Mortgage - Treasury Spread

Is there a light at the end of the tunnel? Investors may be suggesting so with the recent surge in the Dow Jones Industrial Average from its March low below 7000 to a recent peak over 8700. Still, some doubt should exist considering the recent economic data hasn't so much indicated the United States economy is getting better, rather that the economy is worsening at a slower pace. Still there is one area, very close to the epicenter of the economy's troubles, that suggests recent changes are achieving their desired results.

In the 18 months leading up to December, 2008, the spread between 30-year mortgage rates and the benchmark 10-year treasury note rose steadily, reaching a peak at over 3%. This was a period of unprecedented worry over asset quality, as years of declining credit standards were exposed in massive defaults, especially among sub-prime adjustable rate mortgages. These loans had been given at lower standards for credit history or income documentation, and often at higher loan-to-value ratios than conventional mortgages.

As this played out, mortgage lenders introduced a seemingly endless series of guideline updates intended to improve the quality of newly originated mortgages, ranging from adding "declining markets" requirements, and increasing required down payments, to outright program elimination. In addition, mortgage vendors, such as mortgage insurance companies, have tightened their requirements, further reducing mortgage availability. While one result of this is that more borrowers are being turned down for mortgages, the market is recognizing these efforts, and the result can be seen in the current Mortgage - Treasury Spread.

As of June 11th, 2009, the Mortgage - Treasury spread stood at 1.73%, meaning investors required a rate 1.73% higher to justify investing in riskier mortgage assets rather than safer US government securities. The 10-week moving average fell to 1.68%, approaching the historical equilibrium around 1.5% that had stood until the watershed revelations of July, 2007.

The spread briefly reached 1.24% at the end of May, as a surge in Treasury rates had not yet caught up to mortgage pricing.

Several factors preclude the spread returning to the 1.5% level permanently, although it is possible it could settle near this level. The 1.5% level came about in part due to a massive increase in the quantity of assets seeking investments; mortgages replaced stock and treasury investments due to stock volatility and low returns on treasuries. The current economic crisis has erased much of the wealth associated with that period, permanently affecting demand. Addtionally, stocks have presented attractive opportunities of late. However, Treasuries are becoming less desirable compared to other assets due to their increased supply.

In coming months, it is important to be mindful of housing statistics, in particular, to gauge the success of the economic turnaround. Existing Home Sales figures will provide insight into the absorbtion of properties, especially foreclosed properties, into the market. Of particular note is data regarding the supply of existing homes. Until this supply subsides, home-price stabilization cannot be expected to occur. Also important is employment data, as another wave of foreclosures could easily follow from the 6 million or more jobs already lost since the beginning of the recession. If this happens, the Mortgage-Treasury Spread could easily widen. While inflation will be a significant focus of the Federal Reserve, it is not expected to meaningfully impact the Mortgage-Treasury Spread, as inflation impacts both types almost equally. Of note, though is one recent article suggesting that the Fed is facilitating Treasury purchases by buying mortgage-backed securities. This could be dangerous if the Fed is unable to continue and other buyers remain unwilling to participate in the market.

One final thought that has seen little press lately, but likely will in the near future, is the question of duration for new mortgage-backed securities. Duration of a financial asset is the average amount of time in which the investor will receive the proceeds of the investment, and provides a measure of the risk faced on that investment as interest rates change. Essentially, the longer the asset's duration, the greater the risk it faces in a rising rate environment. While most mortgages have either a 15- or 30-year term, their duration is much shorter due to the amortized nature of the loans, and due to natural events such as refinancing or home sale which cause loans to be prepaid.

Several factors in the current environment are likely to cause a shift in expected mortgage duration. Specifically, recent home-price depreciation will extend duration, as homeowners will be less likely to sell or refinance should they have insufficient equity. Second, newly written mortgages at historically low interest rates are less likely to be refinanced in the future, which had been a significant historical factor in shorter mortgage duration. Offsetting these is a possible cultural shift towards debt aversion which may lead homeowners to pay down existing debt more rapidly.

Mortgage risk relative to Treasury risk has decreased significantly in the last 6 months, however, the outlook for the market is still not as clear as investors would like it to be. The continued recovery could be threatened, should market factors impact demand for home purchases. Perhaps the most important news will come shortly, with the Federal Reserve's June meeting. For now, while it is clear that mortgage risk has normalized, whether it will stabilize at this level is anyone's guess.

Dan Hartman is a Senior Mortgage Advisor with Province Mortgage Associates, and also serves as an Adjunct Professor of Finance at the University of New Haven and Roger Williams University. Dan can be reached by commenting on this article, or by phone at (401) 263-8655.